In a recent speech, Narendra Modi said that India needs tax reform. The BJP is reportedly evaluating various reform proposals to include in its manifesto. It is important to evaluate these on the basis of both economic theory and international experience.

The most prominent proposal on tax reform is the one supported by Baba Ramdev. He has proposed a tax on all bank transactions. According to the proposal, such a tax will eliminate “black money”. Money is considered “black” only when the payment of taxes has been evaded. Under a transaction tax regime, evasion is technologically impossible because the bank will be responsible for the collection and payment of taxes, which will take place electronically. Such a tax is supposed to be simple — with little cost of collection, no filing of tax returns and no possibility for evasion.

By implementing this proposal, it is argued that India can get rid of all the complicated taxes it has at present. There will, however, be no taxation of cash transactions because it will be difficult to implement. To ensure that people do not start transacting in cash alone, it is proposed that Rs 500 and Rs 1000 currency notes should be demonetised.

Why is this not a good idea? Transaction taxes are often referred to as “sand in the wheels”. They are meant to discourage certain kinds of transactions. The original “Tobin tax” on currency market transactions was intended to reduce the magnitude of currency trading turnover. Those who argue for transaction taxes do so on the grounds that they will reduce transactions. In other words, it is well understood that when the government starts taxing certain kinds of transactions, people move away from them towards other kinds of transactions. If one method of making payments involves being taxed, people will choose other methods.

Transactions on the street will shift to dollars, gold, bitcoins and other unexpected things. For example, bottles of Tide detergent are reportedly popular as a currency in underworld transactions in the US because they are untraceable. Cigarettes can be used for small transactions. A one cubic centimetre piece of gold weighs 19.1 grams and is worth approximately Rs 56,350. These could be used for larger transactions. This would result in the further decline of the Indian rupee as a trusted vehicle for the storage and transportation of value.

Commentators have highlighted that the international experience of transaction taxes shows that they do